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The Little-Known Way To Profit From Interest Rate Hikes

Oh, to be a banker. Aside from getting an inordinate number of paid holidays (Columbus Day, Flag Day, Arbor Day), you must admit they have a pretty great business model. My local branch pays 0.09% to savings-account depositors and then immediately loans out the proceeds to home buyers at around 5% -- or credit card holders at 18%.

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Multiply that by tens of thousands of customers, and pretty soon you're talking about real money.

Bank of America (NYSE: BAC ) has attracted $45 billion in new deposits over the past year, raising the total to $1.3 trillion. And that low-cost funding has been used to extend $930 billion in loans to various consumer and commercial borrowers. Thanks to rising balances and widening rate spreads, the company pocketed $11.9 billion in net interest income (NII) last quarter.

That's about $132 million per day.

It's a good time to be a lender. But you don't rack up profits like that by being overly generous. Even after eight straight interest rate hikes, the average rate on a 2-year CD is still an anemic 0.94%. But fear not, there's a way to put yourself on the other side of the table.

If you don't like the idea of settling for what the bank gives, then invest in what it receives.

Be The Banker You might have heard of bank loan funds. They are sometimes referred to as senior loans, prime rate loans, syndicated loans, or floating-rate loans. Whatever you call them, they can help buoy your portfolio over the next 12 to 18 months.

So how can individual investors participate in bank loans? Well, once upon a time this asset class was only open to hedge funds and other institutional investors. But since the 1990s, a variety of mutual funds, closed-end funds and even exchange-traded funds (ETFs) have been launched with the sole purpose of holding packaged pools of bank debt.

These loans are typically made to sub-investment-grade companies with less than stellar credit. Because the borrowers don't have the strongest balance sheets, there is some credit risk involved. But that risk is mitigated by two factors.

First, the lenders are protected by restrictive covenants, which prevent the borrowers from taking any action that the bank feels is detrimental to getting its principal back. Second, whereas most bonds are unsecured, these are backed by tangible collateral such as property, equipment and inventory.

As the senior lender, the bank originating these loans is entitled to recover its money ahead of other creditors in the event of non-payment. So, it's first in line. But that's normally not an issue, because defaults have been rare, running around 3% annually over the years (currently just 2.1%).

Even then, a Moody's 15-year study found that recovery rates average 80.3%. That means even the few loans that go belly-up still return 80 cents on the dollar after assets are liquidated. By comparison, recovery rates average 48.5% for senior unsecured bonds and just 28.7 cents on the dollar for subordinated bonds.

But what really makes this group shine in the current environment is that the rates on these loans are variable (or floating) rather than fixed. Most are linked to a short-term benchmark such as the London inter-bank offered rate (LIBOR) plus an extra 4%.

The 3-month LIBOR has crept steadily upward from 2.0% in March to 2.4% today, meaning many bank loans are now paying 6.4%. And if short-term rates continue to rise, so will bank loan yields -- considering their interest rates reset every 30 to 90 days.

Of course, the reverse is also true in a falling rate environment. But the odds of a rate decrease anytime soon are slim to none.

With a traditional corporate or government bond, you are locked into a fixed coupon rate for the life of the instrument. As such, holders can only watch helplessly as interest rates rise and they're locked in for the next five or 10 years. They are faced with an unpleasant choice: stick with the below-market rates until maturity or sell the bond early for a loss.

By contrast, yields on outstanding bank loans ratchet higher within a matter of days. These funds can also reinvest distributions into new securities with higher yields, thereby generating stronger distributions for shareholders.

So this asset class isn't just immune to rate hikes -- it actually welcomes them.

And keep in mind, we're still emerging from the lowest rates on record. It will take another 5 or 6 quarter-point hikes from the Fed for rates to even begin to resemble what we normally see in a healthy economy. The benchmark 10-Year Treasury at 3.1% is still near the low end of the historical spectrum.

So, with muted credit risk and almost zero interest rate risk, bank loan funds are remarkably stable even in tumultuous times. There have been stretches in previous years where net asset values (NAVs) went months without deviating by more than a few pennies per share in either direction.

Make Interest Rates Your Friend There's a reason why variable rate mortgages scare the heck out of people. The higher and faster rates rise, the more interest you pay to the bank. Bank loan funds allow you to turn the tables and flip that scenario.

Even if rates stay flat, my latest Daily Paycheck recommendation already yields 7%. That's more than double the 3.2% you'd get from a 10-year Treasury. And you don't have to tie up your money until 2028 to get that rate -- you can leave anytime. But I don't plan on going anywhere soon.

Unfortunately, I can't share the name of this pick out of fairness to my premium subscribers. But any investor who's worried about rising interest rates and wants to earn a solid income stream should be looking at bank loan funds today.

In the meantime, if you'd like to get the name of this pick -- as well as learn how to access to my entire Daily Paycheck portfolio -- simply go here .

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